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Properly pricing country risk: a model for pricing long-term fundamental risk applied to central and eastern European countries

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Author Info

  • Debora Revoltella

    (UniCredit Group – Bank Austria, CEE Strategic Analysis, Wien)

  • Fabio Mucci

    (UniCredit Group – Bank Austria, CEE Strategic Analysis, Wien)

  • Dubravko Mihaljek

    (Bank for International Settlements, Basel)

Abstract

The private sector has used proxies such as sovereign credit ratings, spreads on sovereign bonds and spreads on sovereign credit default swaps (CDS) to gauge country risk, even though these measures are pricing the risk of default of government bonds, which is different from the risks facing private participants in cross-border financing. Under normal market conditions, the CDS spreads are a very useful source of information on country risk. However, the recent crisis has shown that the CDS spreads might lead to some underpricing or overpricing of fundamentals in the case of excessively low or excessively high risk aversion. In this paper we develop an alternative measure of country risk that extracts the volatile, short-term market sentiment component from the sover eign CDS spread in order to improve its reliability in periods of market distress. We show that adverse market sentiment was a key driver of the sharp increase in sovereign CDS spreads of central and eastern European (CEE) countries during the most severe phase of the crisis. We also show that our measure of country risk sheds some light on the observed stability of cross-border bank flows to CEE banks during the crisis.

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File URL: http://www.ijf.hr/eng/FTP/2010/3/revoltella-mucci-mihaljek.pdf
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Bibliographic Info

Article provided by Institute of Public Finance in its journal Financial Theory and Practice.

Volume (Year): 34 (2010)
Issue (Month): 3 ()
Pages: 219-245

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Handle: RePEc:ipf:finteo:v:34:y:2010:i:3:p:219-245

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Related research

Keywords: country risk; credit default swaps; credit ratings; cross-border flows; financial crisis; central and eastern Europe; foreign-owned banks;

References

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  1. Stulz, Rene M., 2009. "Credit Default Swaps and the Credit Crisis," Working Paper Series 2009-16, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  2. de Haas, Ralph & van Lelyveld, Iman, 2010. "Internal capital markets and lending by multinational bank subsidiaries," Journal of Financial Intermediation, Elsevier, vol. 19(1), pages 1-25, January.
  3. Haibin Zhu, 2004. "An empirical comparison of credit spreads between the bond market and the credit default swap market," BIS Working Papers 160, Bank for International Settlements.
  4. Norden, Lars & Weber, Martin, 2004. "The Comovement of Credit Default Swap, Bond and Stock Markets: An Empirical Analysis," CEPR Discussion Papers 4674, C.E.P.R. Discussion Papers.
  5. Lóránt Varga, 2009. "The information content of Hungarian sovereign CDS spreads," MNB Occasional Papers 2009/78, Magyar Nemzeti Bank (the central bank of Hungary).
  6. Hull, John & Predescu, Mirela & White, Alan, 2004. "The relationship between credit default swap spreads, bond yields, and credit rating announcements," Journal of Banking & Finance, Elsevier, vol. 28(11), pages 2789-2811, November.
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Citations

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Cited by:
  1. Blumenstock, Hendrik & von Grone, Udo & Mehlhorn, Marc & Merkl, Johannes & Pietz, Marcus, 2012. "Einflussfaktoren von CDS-Spreads als Maß für das aktuelle Bonitätsrisiko: Liefert das Rating eine Erklärung?," Bayreuth Working Papers on Finance, Accounting and Taxation (FAcT-Papers) 2012-03, University of Bayreuth, Chair of Finance and Banking.
  2. Aleksandar Naumoski, 2012. "Estimating the country risk premium in emerging markets: the case of the Republic of Macedonia," Financial Theory and Practice, Institute of Public Finance, vol. 36(4), pages 413-434.

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